The terms of trade debate initiated by Raul Prebisch and Hans Singer over 60 years ago continues to this day and is unlikely to be resolved soon. However, even if Prebisch and Singer are right and the terms of trade of countries exporting primary products are falling, to suggest that these countries should diversify away from the production of mineral commodities and other primary products, as many have done, may be poor policy advice, encouraging countries to abandon a promising source of wealth with which to foster economic development.
This is because the prices of most goods are correlated with their production costs. If the prices of primary products are falling but a country's production costs are declining more, the profits, producer surplus, and wealth that the country realizes are rising, increasing the benefits it reaps from its primary product production and trade. Alternatively, when prices are rising but a country's costs are rising faster, the benefits it enjoys are falling notwithstanding higher primary product prices.
While it has long been recognized that falling costs can conceivably offset the adverse effects of lower prices and declining terms of trade for primary product producers, much of the available literature either ignores this likely possibility or contends in fact changes in relative product prices do not reflect changes in their production costs.
The classical economists—Thomas Malthus, David Ricardo, and others—believed that the terms of trade of primary products would rise over time as the limited availability of land and other natural resources pushed their marginal production costs and prices up. In the early 1950s, Prebisch (1950) and Singer (1950) challenged this position, first by claiming that the terms of trade of primary products had fallen over time, and second by advancing several reasons for expecting this downward trend to continue.
In particular, they pointed out that the competitiveness of primary product markets means that the benefits of new, cost-reducing technology are passed on to consumers fully and quickly in the form of lower prices. With manufactured products, in contrast, the managers, owners, and employees of the producing firms are able to retain a good part of the benefits of technological change thanks to their market power. So, less of these benefits are passed on to consumers in the form of lower prices.
In addition, they argued, the long-run demand for primary products is less responsive (or elastic) with respect to income than is the demand for manufactured products. As a result, as income grows over time, the demand for manufactured products and in turn their prices rise more rapidly than is the case for primary products.
The Prebisch and Singer articles ignited a debate that spanned the second half of the 20th century and continues to this day. As Hadass and Williamson (2002) note, the debate encompasses three questions: first, have the terms of trade of primary products in fact declined over the long run? This is the question on which most of the literature focuses. Second, what are the important determinants behind the observed changes in terms of trade? And third, what are the implications for public policy, especially for developing countries that depend on primary commodity exports?
With respect to the implications for public policy, it is fair to say that the work of Prebisch and Singer provided much of the intellectual support for the interventionist policies that many developing countries pursued during the 1950s, 1960s, and 1970s. These policies used protectionism and import substitution to promote domestic manufacturing and economic diversification with generally disappointing results. More recently, proponents of the resource curse thesis—which contends that reliance on the production of mineral and other primary products impedes economic growth in developing countries—have suggested that the declining terms of trade of primary products provides part of the explanation for this perverse result.2
While a comprehensive survey of the terms of trade literature is beyond the scope of this short study, the sections that follow examine each of the three questions noted above. The objective is to show that, although the debate continues, whether the long-run trend in the terms of trade of primary products is falling, stationary, or rising has by itself little or no policy significance for countries exporting primary products. Even if their terms of trade are falling, for many countries exporting primary products is still a promising development strategy, one that creates wealth and resources that they can use to promote economic growth.
The terms of trade debate initiated by Prebisch and Singer over 60 years ago continues to this day, and is unlikely to be resolved soon. For a country exporting primary products, however, whether the terms of trade for primary products are falling, stationary, or rising by itself has little importance. Long-run trends in the real prices of most goods and services largely reflect shifts in their market supply curves and in turn production costs. For somewhat different reasons, prices and costs also tend to move together over the short run.
If the price of a primary product is falling but a country's production costs are falling more, then the wealth the country realizes in the form of producer surplus is rising, increasing the benefits it receives from its production and trade. Alternatively, if price is rising but a country's costs are rising more, the benefits from production and trade are falling despite the rising price.
As a result, even if the terms of trade of primary products are falling, to suggest that countries should diversify away from their production, as Prebisch, Singer, and others over the years have done, makes little sense. Indeed, it may very well be counterproductive, encouraging countries to abandon what is a promising path to faster economic development.
